World economy: OPEC deal likely to be extended

OPEC representatives have said that support is growing among member countries for an extension of the current production cut agreement, which is set to expire in June. Initial compliance with the production quotas by OPEC members has hit record levels, and several non-OPEC participants, such as Russia, are also delivering their promised cuts. Nonetheless, the market fundamentals that have supported a modest recovery in global oil prices in early 2017 appear to be eroding, making for a more bearish outlook.

The oil production quotas agreed by OPEC members in November 2016 signalled a clear shift away from the "free for all" market strategy that has dominated in recent years—when many Gulf countries kept pumping in order to preserve their market share in the face of higher US shale oil production. However, oil producers have begun to buckle under the fiscal pressure caused by weak global prices, which has been particularly acute for many Gulf countries that rely on oil rent to prop up massive public spending.

Origins of an agreement

Greater pragmatism from Saudi Arabia's oil minister, Khalid al‑Falih, as well as Iran (whose production is nearing pre-sanctions levels), allowed the landmark production cuts to be agreed in November. Thus far, participants have largely stuck to their promises. The most recent data from the International Energy Agency show that OPEC met 98% of its pledged cuts in January-February—largely owing to Saudi willingness to make even deeper than expected cuts in order to compensate for weaker compliance elsewhere, including Iraq, the UAE and Venezuela.

Non-OPEC countries such as Russia and Kazakhstan have also reined in their production in early 2017. Russia's energy minister, Aleksandr Novak, has said that the country will meet its pledged 300,000‑barrel/day (b/d) cut by end‑April. Although Russia's commitment to maintaining lower production in the longer term remains uncertain, the level of co-ordination demonstrated thus far has been unprecedented.

Shifting market fundamentals

We expect major producers to maintain this pragmatic approach throughout the rest of the year, as oil producers have little appetite or capacity to deal with a renewed drop in global oil prices. The November agreement provided an immediate, sentiment-driven boost to global oil prices. The price of dated Brent blend, the international benchmark, jumped to US$55/barrel in December 2016, and then held within a relatively tight band of US$55/b‑US$57/b in January and February.

However, these gains have eroded quickly in recent weeks, as the global supply glut is likely to persist. For one, US shale producers have ramped up investment quickly—the US rig count hit 789 active rigs on March 17th, an increase of 65% year on year, according to an oil services firm, Baker Hughes—which will accelerate the recovery in more cost-efficient US shale production. In addition, global crude and refined energy stockpiles remain well above the previous five‑year average, particularly in the US, in part owing to warmer winter weather.

Once will not be enough

As a result, The Economist Intelligence Unit estimates that it will take longer than six months to rebalance the market, making it likely that the OPEC agreement will be extended until December 2017. Indeed, if the deal were to dissolve in June, this would bring roughly 1m b/d in foregone OPEC production back on stream. Together with an anticipated rise in US output, this could cause global oil prices to plummet back below US$50/b.

For oil producers, this would be undesirable for several reasons. Market speculators have built up a heavy "net long" position in early 2017 (in which hedge funds accumulate a large proportion of futures contracts, on the assumption that oil prices would rise even faster than market expectation). A weaker outlook for oil prices in 2017, caused by an influx of supply in June, could prompt a disorderly sell-off in these assets, which would undermine prices further. Indeed, traders have already begun a modest sell-off in mid‑March, when the price of Brent crude temporarily dipped closer to US$50/b, from over US$58/b in February.

Furthermore, Saudi Arabia will be intent on keeping oil prices as high as possible as it prepares to sell up to a 5% stake in the national oil firm, Saudi Aramco, in 2018. Higher global oil prices will be critical to ensure that the company receives a high valuation (the authorities are targeting an ambitious value of US$2trn), which will help to head off domestic criticism that the state is selling off its important assets at a time of fiscal strain.

Co-operation is critical to the deal's extension

Mr Falih has said that it would be premature to discuss the deal's extension before OPEC's next meeting on May 25th, and a number of factors could influence the market in the interim. However, the anticipated rise in US shale oil production and the economic necessity of maintaining high oil prices for many Gulf producers (even at the extent of some lost market share) mean that the production cut agreement is likely to be extended by another six months. Against this backdrop, we will maintain our forecast that Brent crude prices will rise this year, to an average of US$56/b in 2017, from just over US$44/b in 2016.

The critical point, however, will be whether or not non-OPEC producers are willing to exercise restraint. If Saudi Arabia and its Gulf allies perceive that other producers are boosting their output in order to take advantage of price gains generated by the OPEC deal, the agreement is likely to fall apart. If so, this would most likely result in a renewed oil price drop (albeit not to the lows experienced in 2015‑16, as global demand remains relatively firm).